Investors Preference for Lottery Stocks and the Cross Sectional of Bank Equity Returns

Recent empirical evidence has uncovered a size effect in banks equity returns (Gandhi and Lustig, (2015)). In a recent work we documented that the generated lower returns associated with bigger size primarily holds during normal periods but are insignificant or reverses sign during crises. The protection provided by implicit government guarantee is an insurance type contract characterized by the payment of premiums during normal times involving lower required returns in expectation of government protection subsidies and higher returns during crises. The negative size/return relationship will thus hold only during non-crisis, when investors are buying protection, and will be reversed during crises when the insurance is collected. This mechanism is similar to the exercise of an American type put (protective) option when it will become deeply in the money (during crises). A natural question that raises from the above analysis is if this protective mechanism creates incentives towards opportunistic behavior and thus encourage to take higher risk activities. Our evidence indicates that protected big banks with lower left tail have relatively fatter right tail and market beta, suggesting that they may follow riskier policies. But do investors in bank equities have also preferences for lottery type feature? In other word is the documented preferences for protective options in bank equities an isolate phenomena or are indeed part of a more general preference for lottery type stocks? Preference for lottery stocks has been widely documented in the non-financial industry (see Kumar (2009), Conrad et al. (forthcoming)) but to our knowledge this would be the first project in studying preferences for lottery type stocks for financial institutions.

Recent empirical evidence has uncovered a size effect in banks equity returns (Gandhi and Lustig, (2015)). In a recent work we documented that the generated lower returns associated with bigger size primarily holds during normal periods but are insignificant or reverses sign during crises. The protection provided by implicit government guarantee is an insurance type contract characterized by the payment of premiums during normal times involving lower required returns in expectation of government protection subsidies and higher returns during crises. The negative size/return relationship will thus hold only during non-crisis, when investors are buying protection, and will be reversed during crises when the insurance is collected. This mechanism is similar to the exercise of an American type put (protective) option when it will become deeply in the money (during crises). A natural question that raises from the above analysis is if this protective mechanism creates incentives towards opportunistic behavior and thus encourage to take higher risk activities. Our evidence indicates that protected big banks with lower left tail have relatively fatter right tail and market beta, suggesting that they may follow riskier policies. But do investors in bank equities have also preferences for lottery type feature? In other word is the documented preferences for protective options in bank equities an isolate phenomena or are indeed part of a more general preference for lottery type stocks? Preference for lottery stocks has been widely documented in the non-financial industry (see Kumar (2009), Conrad et al. (forthcoming)) but to our knowledge this would be the first project in studying preferences for lottery type stocks for financial institutions.